This month we expand our horizons. In addition to my voice, we add that of Advisor Jeff Heyer-Jones. My discussion this month is how to scan your business for earnings at any time. This economy is full of zigs and zags. Some of our clients are holding their breath for things to improve, some are trying to figure out how to deal with another record year. …and next quarter the roles may be reversed. This month we look at how to assess your business for earnings opportunities in any weather, then Jeff takes us a little deeper into customer profitability analysis through a brief case study.
Finding Earnings in Any Weather
I spoke last month at IBIE in Las Vegas and presented on this topic. Attendees of my session received our 2022 monograph: Earnings Growth which covers this topic in more detail. If you’re interested in receiving a copy, MBR Readers may receive it. Just send me an email request.
There are two answers to the question of how should I increase earnings? If you are in a hurry, and you need to move the needle this quarter, or possibly even this month, look to pricing. Pricing is the most powerful lever of earnings (Buffet says so) and it works the fastest, provided you are conducting transactions throughout the year. If you negotiate all your contracts once a year, this is not so fast, but for most it is both the most powerful and the fastest route to earnings improvement. Bear in mind, I’m not talking about giant leaps in pricing that make up for a decade of not raising prices, but rather small increments that are available by making changes that we refer to as “on us”, where the business has discretion as to how things appear on the invoice.
Pricing is a discipline of details. We’ve got a list of 150 things to review in a client’s pricing activities, many of which don’t apply to any given client because in their business they aren’t relevant. However, by creating a few charts, a pricing waterfall, pricing by margin bucket, margin by customer volume, the business can quickly identify areas of improvement that can be put in place with immediate effect. We’re talking small percentages here. Perhaps 3.5% of revenue. Which goes straight to the profit line. When you improve price performance, there is no increase in costs.
And for most businesses, an increase of 2-3% won’t even be noticed by their customers. But could mean bug relief in their efforts at making sustainable earnings growth. Of course, depending on where your business is, there may be other lower hanging fruit. We deal with the more nuanced story in our monograph, but for many, this is a great start and will fund future efforts.
What Does a good customer look like?
Not all customers are good customers and some customers you pay for having the privilege of providing a service or product. Do you know how your customers measure up? All businesses, whether commercial or missions driven must make money to be sustainable. Having a diverse and profitable customer mix drives profitability.
Figure out your cost pools
Cost pools allow you to view your P&L and determine the 80/20 rule for your business. Are your costs mostly labor with a little material? Or are they mostly material with a little bit of labor? The types of costs your business has drives the actions required to improve those costs. So just getting in touch with your cost pools and which ones are the big ones is valuable. Cost pools are especially valuable in that they can be associated with customers to understand the attractiveness of individual customers. In addition to categorizing them by the sort of cost they are, they can be identified as direct costs, indirect costs, and selling, general & administrative costs (SG&A). Direct costs are those than can be associated with a specific product or customer.
Using a simple car example, direct costs are the materials and labor required to make each car. Continuing with this example, Indirect costs are costs related to making cars, but that don’t wind up in the car so-to-speak i.e. cost of lighting the factory. If you make fewer cars, you don’t have to turn the lights on as long, so the cost of lighting (electricity) varies with the number of cars you make. You can’t make cars without the lights on, but the electric bill isn’t associated with one specific car. SG&A costs are necessary costs, but they don’t cary with production or operations activity. AN example would be the cost of the sales force or your accountant. You need them, but if you produce fewer cars this month, you won’t need half an accountant. In the long run, as the adage goes, all costs are variable. If you produce fewer cars long enough you could reduce your accounting staff, but you wouldn’t do it month to month.
Develop your drivers for each cost pool
Now that you have identified your major cost pools, brainstorm and determine what drives the cost for each of the pools. These should be things that can be counted and assigned to customers. This is a mix of art and science. Experience is valuable here. The goal is to have the driver be granular enough to drive expenses down and be a true reason for the costs. Examples that we’ve set for our clients include things such as product or service units, customer special demands, internal work products etc. In the car making example, these might be option level of the cars being made, model etc.
Allocate Costs & Segmentation
Allocate your costs to customers using your drivers. The goal is to assign the costs to customers and compare a customer’s total costs to the revenue that the customer generates in a specific study period such as a fiscal year.
Make decisions
Using the model, you can drive business decisions focused on driving profitability. Some things to consider:
• Do you need to raise prices to cover a customers costs?
• What would happen if you deepened your relationship with the most profitable customers? Can you expand your relationship with them?
• What customers are hallmark customers that are costing you money, but might make sense to continue to have as a customer? And importantly, how much other business do they need to bring you to make up for their cost structure?
• What does an ideal customer mix look like for your business?
Call to action
Ask yourself – how well do you know your customers and how they drive profitability for your business? If you’re unable to answer this with data, looking at profitability by customer is a great way to understand what a good customer looks like to drive company profitability. To do this you’ll need to:
1. Identify your cost pools
2. Develop your drivers of cost
3. Allocate & segment customers
I hope you found something to apply to your business in this MBR. Let me know either way.
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